Comparing the average PER of a current stock market index with what it was historically is a simplistic approximation. It can lead to the wrong conclusions if we don’t take into account the differences in ROE (which determine what part of profits can be distributed to shareholders). And, above all, if we don’t consider the scenario of returns which the investment offers without risk, if we compare multiples without taking interest rates into account.
In the big stock market indices (S&P 500 in the US, Euro Stoxx 50 in the Eurozone) companies with a greater ROE have been gaining more weight. That in itself would justify higher trading multiples. To illustrate this phenomenon, we have compared the trend in the weighting of the different sectors in the Euro Stoxx 50, from the end of the XX century (1999) to today. What we can see is that the change in the composition of that index, over a not excessively long period of time, has been significant.
In 1999, the lion’s share of the weighting of the Euro Stoxx 50 was taken up by the financial sector (25%), and, above all, by public services, the former monopolies of production and distribution of fuels, energy and electricity and telecommunications operators (42%). So, overall, two thirds of the index depended on sectors with a basically local and very regulated sales component. The weighting of industrial and consumer sector companies, open to more global markets and subject to free competition, did not reach, in total, more than a third of the index in terms of their weighting.
In 2017, 18 years later, the situation has been reversed. The financial sector, and especially, public services’ companies have seen their weighting significantly reduced in favour of big global players from the industrial and consumer sectors. If 18 years ago the telecoms operators lead the market capitalisation rankings in the main countries in the Eurozone (Deutsche Telekom, Orange, Telefónica were the leaders in Germany, France and Spain), today they have had to give up their place to other companies (SAP, LVMH and Inditex), global leaders in their respective sectors.
So currently, the weighting of the non-regulated sectors, consumer and industry, is now over two-thirds of the index, while the regulated sectors (financial and public services) have a weighting of just around a third.
Globalisation, something which has been taken good advantage of by a large number of European industrial and consumer companies (Siemens, Bayer, L’Oréal, LVMH, Inditex, SAP, Unilever, AB Inbev, Daimler, BMW), has been the determining factor behind the radical change in the weightings in the Euro Stoxx 50 so far during the XXI. The other major macro trend, the explosion of the digital economy, has not really been reflected in any significant way in the European stock market. That said, it has had a very decisive impact on the change in composition of the main north American stock market indices.
A quick look at the list of the ten leading companies in the US market, ranked by market capitalisation, clearly shows this. Five of the ten companies with the highest stock market valuation (and amongst them, the three which lead the ranking) are genuine representatives of new technology, of the new digital era. And only one of them, Microsoft, had a reasonable size at the end of the last century.
The global indices have seen a shift in their composition from regulated to non-regulated companies, from local firms to global ones, from modest growth to strong growth (particularly in the case of the technology sector), from high levels of investment and low returns to low levels of investment and high returns, from low ROE to high ROE. For that reason, amongst other reasons (like the interest rate situation), the big stock market indices deserve to trade at ratios which are much higher than those in the past.
* Photo: Flickr/Tasayu Tasnaphun